Oil recovery ignores fundamentals

By Javier Blas in London Published: May 19 2009 20:01 Last updated: May 19 2009 20:01 Take a quick look at the oil price and you would think the market is rapidly returning to health. On Tuesday, the market’s main benchmark – West Texas Intermediate – jumped to a six-month high of $60.48 a barrel, up 85 per cent from February’s low of $32.7. Dig deeper into the world of physical oil and another picture emerges, however: the fundamentals of supply and demand are weak – much weaker than current prices imply. Traders – some of the top executives at the world’s largest oil companies – say the recent rise in oil prices is due to investor flows and bets about long-term supply and demand, rather than any improvement in the near-term physical market. “It is difficult to reconcile the fundamentals with the surge in the prices,” a senior executive at a large trading house says, reflecting a widely shared view. “The move from $50 to $60 was not based on fundamentals,” adds another top executive at an important bank which trades physical oil. EDITOR’S CHOICE Financials push Footsie to four-month high - May-19Demand from China lifts US soyabean prices - May-19Blog: Energy Source - May-18Overview: US fear gauge signals signs of improvement - May-19To be sure, traders are not forecasting a return of the lows of the year of $30 a barrel. But many reckon prices need to fall $10 in order to align with fundamentals. Most analysts agree. Adam Sieminski, chief energy analyst at Deutsche Bank in Washington, says: “Oil prices have been supported by rising sentiment in the equity markets.” Jeffrey Currie, head of commodities research at Goldman Sachs in London, says, while oil investors have been pricing-in the improving economic outlook, “the market can only do this as long as there is room to store the oil and bridge the gap between the currently weak demand environment and the anticipated stronger forward fundamentals. “With inventories already at record levels, the risk is that oil inventories [will] breach storage capacity and force spot prices lower,”he adds. However, some analysts – and a few traders – disagree. They believe the surge does not represent any violation of fundamentals. On the contrary, Costanza Jacazio, an oil analyst at Barclays Capital in New York, reckons the rise is the result of “one of the most important” fundamentals, namely that prices at $40-$50 leave the market “dangerously far from equilibrium” in the long term. The conflicting views suggest next week’s Opec meeting in Vienna could be even more difficult than usual, with ministers caught between bearish near-term physical fundamentals and a bullish futures market. Opec – with a vested interest in talking up the market – agrees with the downbeat physical traders’ view, downplaying the sustainability of recent prices. In its latest monthly report, published last week, the cartel said oil prices “have remained above $50 a barrel due more to market sentiment than [to] fundamentals”. “Considerable risks remain as oil market fundamentals are far from balanced due to the persistent contraction in demand and growing supply overhang,” it said. Demand is contracting at its fastest pace since 1981. The International Energy Agency, the western countries’ oil watchdog, forecasts a fall in consumption of 2.6m barrels a day this year compared with 2008. Such a fall would wipe out five years of demand growth, pushing average oil consumption this year to 83.2m b/d, the lowest since 2004. Traders say although demand appears to have hit a bottom – in part due to the seasonal pick-up in demand as the summer’s driving season arrives – there is little sign consumption will rise substantially in the near-term. The supply front is even more worrying for the oil bulls. After eight consecutive months of Opec production cuts, the cartel marginally lifted its production in April and it appears certain another increase will follow this month. Nonetheless, overall compliance with the cuts – at 80 per cent of the promised 4.2m b/d – is still impressive by historical standards. At the same time, non-Opec production has held up better than expected in spite of mature oil fields in areas such as the North Sea, Alaska and Mexico and lower investment elsewhere. Overall, global oil production increased last month for the first time since October, rising 230,000 b/d to 83.6m b/d. With demand this quarter estimated at only 82.3m b/d, more oil was forced into storage, bringing inventories to record levels. Developed countries’ onshore inventories surged counter-seasonally in the first quarter and preliminary data suggest they increased further in March and April. Measured as days of demand, OECD total inventories are today enough to cover a massive 62.4 days of consumption, much more than the traditional range of 50-55 days. Although developing countries’ statistics on inventories are, at best, sketchy, traders reckon they also increased in the first quarter, notably in China. What is more, a record amount of crude oil and oil products is floating at sea in tankers. Traders estimate about 100m barrels of crude and about 25-30m barrels of oil products – mostly distillates such as diesel and kerosene – are sitting in tankerswaiting for a pick-up in demand. That would represent a 40 per cent increase uponfloating storage levels in late March. “Taking in account supply, demand and stocks, we should see oil at $40 rather than $60,” one senior oil trader estimates.